CML news & views

When a funding market crisis followed hot on the heels of a collapse in the sub-prime sector, US mortgage and housing markets were swept up in a storm. 

Some feared that similar problems would create a whirlwind here too, but the causes of the housing market downturn were different in the US and the UK. So, how has the housing market downturn in each country played out and how has each been affected by the financial storm?

The economic backdrop

Both countries have been through a wider economic recession. The US economy shrank by about 4% from the middle of 2008 to mid-2009. The UK economy came off a little worse, with a decline of just under 6% over the same period. But the pattern of mortgage defaults in the two countries tells a very contrasting story.

US mortgage arrears rates began to rise in 2006, and continued to increase sharply. Over 9% of all US mortgages are now 30 days or more in arrears.

When looking at arrears over a longer period, it is easier to make comparisons between the UK and the US (although they are still not directly comparable). The Mortgage Bankers Association of America (MBAA) reports data based on mortgages 90 days or more in arrears. And in the UK, we report the number of mortgages more than three months in arrears.

The numbers show that the trends in the two countries have contrasted sharply. Since 2004, the share of US mortgages 90 days or more behind has risen from a little below 1% to over 5%. Over the same period, the UK has seen a far more modest increase, from a similar starting point to 2.4% at the end of the third quarter of 2009. Why should this be so?

Chart 1: Mortgage arrears – 90 days+, 3 months or more

Source: MBAA, CML
Notes: The US series refers to all mortgages 90 days or more in arrears. From Q3 2007, the series is estimated using partial sector splits. The UK series is the share of mortgages more than three months in arrears. Both series refer to first charge (known as first lien in the US) mortgages only.

(Text continues below, following an explanation of the US foreclosure process.)

What the data shows

Despite a lack of directly comparable data on possessions, the overall picture is clear - the US has faced far higher rates than we have seen in the UK.

The MBAA’s most recent data shows US lenders starting foreclosure proceedings against around 1.4% of borrowers every three months and that around 4.5% of loans are currently in the foreclosure process.

Data from Realtytrac shows that there were around 850,000 full possessions (option 4 in our box explaining the foreclosure process) in the US in 2008, and that the number is likely to increase in 2009. The number of cases in this relatively narrow definition of possession equates to around 1.6% of the total of around 55 million first charge US mortgages.

If cases sold at public auction are added in, the total would more than double. But both these measures are likely to include some second (or additional) charge cases, which the CML’s UK data does not.

In the UK, we saw 40,000 possessions in 2008 on first-charge mortgages, equating to 0.36% of the 11 million outstanding loans. And the CML anticipates 48,000 cases in 2009 – or 0.44% of all mortgages.

The US problem is sub-prime…isn’t it?

The US data also shows some interesting developments in the type of borrower facing foreclosure.

What clearly started out as a problem in the sub-prime sector then fed through into the wider economy and mainstream loans. Sub-prime foreclosure starts have now begun to fall, while prime foreclosures are still on the way up. This confirms what is generally acknowledged, that the initial US problem was one of underwriting standards – that is, advancing mortgages to people who could not continue to afford to pay, even under relatively benign economic conditions.

The recent rise in prime foreclosures appears to reflect the emergence of a more typical part of the economic cycle – borrowers who can pay their mortgages in “normal” circumstances but who are undone by a loss of income.

Chart 2: US foreclosure starts

Source: MBAA
Notes: Share of mortgages that enter the foreclosure process in each quarter

Why the difference?

So why, despite a deeper recession in the UK, have we not experienced problems on the same scale? There are a number of reasons.

While most commentators anticipate some further increase in unemployment in the UK, the rise has not been as sharp as many feared even a few months ago. In fact, we are now seeing tentative signs of stabilisation. Unemployment in the UK has risen from 5.2% of the workforce at the start of 2008 to 7.8% now, but in the US the rate increased from 4.9% to 10.2% over the same period.

Chart 3: US and UK unemployment rate

Source: ONS, Bureau of Labour Statistics
Notes: The data refer to the share of the workforce not in employment

Interest rates – a key factor

Borrowers in the UK have benefitted more directly than their US counterparts from the exceptionally low levels of official interest rates. The UK is quite unusual in having a relatively high proportion of variable rate mortgages that contractually track official rates. That means a large number of UK borrowers have seen their monthly payments fall sharply.

Some US rates are trackers but few, if any, are contractually tied to the federal funds rate. Many others are fixed for the whole term. Borrowers, where they have enough equity, can re-finance, but very few will be able to borrow at the exceptionally low rates of interest many UK borrowers currently find themselves paying.

There is a flip side to this, however. The Bank of England will not keep rates at current levels forever and, when rates do rise, some UK borrowers will face significantly higher monthly payments.

Chart 4: US and UK house price growth

 
Source: Case-Shiller/S&P US house price index for largest 10 cities, Halifax house price index

House prices – wider fluctuations?

Another point worth considering is that US house prices have traditionally been far more stable than in the UK, with some commentators ascribing this to greater flexibility in housing supply. With more land available and less restrictive planning constraints, US developers can respond to increased demand more quickly. So, large imbalances between supply and demand are less likely to build up. In the period before the credit crunch, the US had not seen prices either rise or fall as sharply as in the UK.

In this cycle, however, the cumulative decline in prices has been larger in the US, with a peak-to-trough drop of nearly 35% compared to 21% here. Weak equity positions have led to a large amount of “jingle mail” in the US – where borrowers who are “underwater” (as Americans refer to negative equity) simply abandon their home and post the keys to the lender.

This increased incidence of “walk-aways” compared to experience in the UK is likely to be driven by two related factors. Firstly, US borrowers and lenders are less used to dealing with negative equity. It was quite extensive here in the early 1990s, with most borrowers who experienced it working their way through it over time. Secondly, some US states have “non-recourse” laws – meaning that lenders cannot pursue borrowers for debts over and above the price for which a foreclosed property is sold. Even in states that do not have these laws, lenders often consider it too expensive to be worth pursuing shortfalls.

In the UK, however, borrowers remain liable for any shortfall and can be pursued for it for several years. This probably means that US borrowers, often with larger levels of negative equity, are more likely to walk away.

The UK – better lending quality

The far higher rates of US default support the view that, despite earlier fears to the contrary, UK mortgage lending in the middle part of this decade did not suffer from the same excesses and lax lending standards.

An exact definition of sub-prime lending remains elusive, but the MBAA reported that around 14% of outstanding mortgages covered in its national delinquency survey were in this category at the peak a few years ago. There is no such categorisation in the UK, but we have previously estimated that adverse credit borrowing may have accounted for between 6% and 8% of all loans at its peak.

But within this group of borrowers, there is little evidence that the UK saw “risk layering” of mortgage products to anything like the same extent as occurred in the US. There, lending to borrowers who are at risk from a combination of factors – with, for example, a poor credit rating, unstable employment record and high loan-to-income multiple – has been much more common.

Where next?

Lending standards have been more rigorously upheld in the UK, and we have not experienced payment problems on the same scale as the US. But we cannot be complacent. The recession and the loss of income faced by many UK households will mean that we are likely to see some further increase in mortgage arrears, particularly once interest rates start to rise. And the likely fiscal consolidation expected to occur in the coming years could lead to a further rise in unemployment.